Unusual cyclical dynamics is taking investor risk appetite on a journey

World industrial production (IP) is growing at trend pace, rising by roughly 3% in the year-to-June. What is interesting is that world IP is continuing to grow at a robust pace despite leading reliable indicators like the Institute of Supply Management (ISM) new orders index falling into contraction territory. This is true whether we include “smoothed out” Chinese data, or not. Further, we are also seeing U.S. retail sales growing at a solid pace despite consumer confidence pointing to weakness. In short, we are noticing some decoupling between “hard” and “soft” data.

World IP and ISM new orders

U.S. retail sales and consumer confidence

U.S. retail sales and labour income

U.S. retail sales volumes lead world IP. This is because the U.S. consumer is the buyer of last resort of goods produced globally. Despite high uncertainty from tariffs, the U.S. consumer is being supported by real labour income growth, credit availability, and recovery in asset prices. In turn, the U.S. consumer is supporting the global goods cycle. Historical relationships suggest that there may even be scope for world IP to overshoot U.S. real retail sales, because the U.S. dollar (USD) has been weak of late, and USD weakness usually supports global liquidity and trade financing. If history repeats itself, we should see world IP growth pick up to an above-trend pace, consistent with rising commodity prices. In turn, rising commodity prices would support resources exposures in the equity market, and higher inflation pricing in bonds.

World IP and U.S. retail sales

World IP, U.S. retail sales and USD

Commodity prices and world IP

We mention all of this to illustrate important cyclical dynamics that take investor risk appetite on a journey. In the first place, we think that the key reason why sentiment indicators are not predicting real economy outcomes very well, is that money markets are not under duress. Historically, material weakness in market sentiment is correlated with funding stresses… but the post-Liberation Day experience suggests otherwise. Indeed, we think that ever since 2019, policy makers have gone the extra mile to protect money markets. Unsurprisingly, the forecasting errors we see in sentiment indicators with respect to world IP and U.S. retail sales, are highly correlated with movements in key funding signals like financial system leverage and swap spreads.

Secondly, and related to this, the prospect of slower world growth flagged by sentiment indicators is usually a reason to buy bonds – both because of defensive properties and disinflation risks. But this time around, it is the lack of funding stress in money markets that is preserving the easiness of financial conditions and upholding the cycle. To a point, easing rhetoric from central bankers can support bonds and prop up the cycle at the same time, because they are not easing in response to bad news (funding stresses). But beyond this point, the risk is that world growth re-acceleration causes commodity prices and inflation pressures to rise, undermining the credibility of central bankers to ease policy.

To position for all of this, a portfolio needs to be able to position for both sides of the above dynamics. In other words, it needs to be positioned for near-term “risk on” from the suppression of bond yields by policy makers and leveraged bond buyers. But it also needs to be protected against the likelihood of higher inflation from easing financial conditions and re-accelerating world growth. Indeed, this is all before even considering the inflationary repercussions of tariffs, fiscal deficit intentions and geo-political risk factors. In a multi-asset portfolio, the best way to hedge against bond yield suppression is to take on more equity exposure in selected growth names, and to generate income through credit exposure, because bonds and credit are levered to the unusually low bond yields. To hedge against the risks of inflation and bond yields gradually rising, a debt portfolio needs to have shorter-than-benchmark duration while an equity portfolio needs to be contrarian, or positioned for the unwinding of crowded trades. In the Australian context, resources names certainly meet this criteria. Quality and value overlays can eventually become useful – but only when we see proper de-leveraging in the fixed income space.